The Bank of Japan kept its benchmark interest rate at 1% on July 31, as expected by all surveyed economists following its June hike to a 31-year high. The Bank of Japan is also intervening in currency markets to defend the yen, which is trading near 40-year lows.
The Japanese Policy Board voted 8 to 1 to keep the benchmark interest rate at 1%. Reportedly, the sole dissenting board member was Hajime Takata, who again argued for raising the rate to 1.25% due to a more hawkish inflation outlook.
Nonetheless, economists had expected the board to keep interest rates steady. However, the market was interested in what tone the Bank of Japan would set going forward. In its statement, the Bank of Japan appeared to take a hawkish stance, warning in its forecast that underlying inflation is likely to accelerate. The Bank of Japan expects underlying inflation to exceed 2% starting from the second half of the fiscal year.
Inflation Outlook Turns More Hawkish Despite Unchanged Forecast
Japan's underlying inflation in July was 1.6%, meaning it has largely remained below the Bank of Japan's 2% target for most of the year. Despite the persistent trend, the Bank of Japan lowered its underlying inflation forecast for FY 2026 to 2.5% from the 2.8% forecast in April. This new adjustment represents a downward revision that at first glance appears 'dovish'.
However, Bank of Japan officials pointed to lower near-term figures while expressing firmer confidence that the overshoot would occur later. The Bank of Japan argued this overshoot would be driven by rising import costs associated with the weak yen, sustained corporate pricing behavior, and lingering effects from the energy shock caused by the Middle East situation earlier this year.
Economists had expected near-term dovishness alongside long-term hawkishness, forecasting that the Bank of Japan, while keeping rates steady, intended to send a hawkish signal.
The market eagerly awaited the press conference by central bank governor Ueda following the decision. Many believed that despite most central bank members voting to keep interest rates unchanged, this policy could still significantly impact the yen's exchange rate.
Analysts were divided on whether the next rate hike would be in October or pushed to December, and Ueda's task was to reconcile a government led by Prime Minister Sanae Takaichi, which showed little appetite for further monetary tightening, with a bond market that had already priced in further tightening.
Yen Intervention Adds Another Unexpected Twist to the Situation
It is also reported that the Bank of Japan directly intervened in currency markets several hours before the interest rate decision. Sources indicated that Japan conducted an intervention in New York on Thursday, buying yen and selling dollars. This was the Bank of Japan's first use of such tactics in three months. The yen fell to a 40-year low against the dollar, threatening to further increase prices for imported energy and food.
In 2026, yen weakness has been exacerbated by three separate factors. The significant interest rate differential between the US and Japan is sustaining carry trade activity. Similarly, high fuel prices due to tensions in the Strait of Hormuz and the market's reluctance to respond to the Bank of Japan's willingness to narrow the gap quickly enough. These three factors have driven the yield on Japan's benchmark 10-year government bonds down to 2.8%, indicating that bond investors are already pricing in further tightening of the central bank's monetary policy.
